Recent decisions from the Delaware Court of Chancery indicate that these courts are beginning to limit enforcement of non-competition covenants entered in connection with the sale of a business and deemed by the courts to be overly-broad. As opposed to non-competes in the employment context, where courts have consistently sought to ensure the reasonableness of the scope, duration, and geographic area of a non-competition provision, courts have traditionally taken a more lenient approach when evaluating non-competes entered into in connection with the sale of business as the parties who enter into non-competes in the business sale context are presumed to have (i) more equal bargaining power and (ii) the ability to negotiate the terms of the non-compete in the broader context of the business sale.
The Court of Chancery recently displayed a shift in this historical approach through two recent decisions in which the Court deemed non-compete covenants in connection with the sale of a business to be overbroad and therefore unenforceable. In the first case, Kodiak Building Partners, LLC v. Adams, C.A. No. 2022-0311-MTZ (Del. Ch. Oct. 6, 2022), Kodiak Building Partners, LLC (“Kodiak”) acquired Northwest Building Components, Inc. (“Northwest”). In connection with the sale, Philip Adams, an owner of Northwest and its general manager, received a payment of $1 million. As part of this transaction, Adams signed an agreement containing restrictive covenants prohibiting him from engaging in activities which competed with the “Business” of Northwest in the States of Idaho and Washington, or within a one hundred (100)-mile radius of any other location outside of Idaho and Washington in which Northwest and Kodiak, and its subsidiaries and affiliates, provided products or services within twelve (12) months prior to consummating the transaction. In Kodiak, the underlying restrictive covenants agreement defined “Business” to include activities which were not part of Northwest’s operations. Further, the non-compete covenant covered Kodiak, its affiliates, and subsidiaries, which the Court described as Northwest’s “preexisting goodwill that predated the acquirer’s purchase of the target.” The Court concluded that this coverage did not constitute a “legitimate business interest,” a condition for upholding a non-compete as reasonable in scope and duration. The Court therefore ruled that the non-compete was overbroad and unenforceable. Lastly, the Court also ruled that although Adams signed a waiver acknowledging the agreement as reasonable and valid, the Court reserved its right to analyze the covenant’s reasonableness.
In the second case, Intertek Testing Services NA, Inc. v. Eastman, C.A. No. 2022-0853-L WW (Del. Ch. Mar. 16, 2023), Intertek Testing Services Na, Inc. (“Intertek”) acquired Alchemy Investment Holdings, Inc. (“Alchemy”) and its subsidiaries through a stock purchase. Jeff Eastman, Alchemy’s cofounder, major stockholder, and Chief Executive Officer, received $10 million in exchange for his ownership interest in Alchemy. The purchase agreement contained a non-compete clause which prohibited Eastman from competing with Alchemy anywhere in the world for a period of five years. More than two (2) years following this transaction, Eastman began working for a company in the cannabis industry, pursuant to which Alchemy filed suit claiming that Eastman violated the non-compete covenant. The Court undertook a review of the reasonableness of Eastman’s non-compete covenant, emphasizing that broad restrictive covenants must (i) be tailored to the seller’s so-called “competitive sphere” of the seller, and (ii) serve the buyer’s legitimate economic interests. Due to the inconsistency between the geographic scope of the non-compete and Alchemy’s “national market”, the Court held Eastman’s non-compete to be unreasonably broad in scope, and, therefore, unenforceable with respect to Eastman’s new role in the cannabis industry.
It is important to note that in both of these cases, the Court refused to narrow covenants deemed overbroad and enforce these covenants in-part (as permissible under the so-called “blue pencil” provision of the transaction documents executed by Kodiak and Eastman). The Court noted that although, in the past, it has enforced restrictive covenants in-part under “blue pencil” provisions, Courts reserve the discretion to decline to enforce restrictive covenants in part when such enforcement would otherwise grant sophisticated parties relief with respect to drafting overly broad covenants. In other words, drafting overly broad covenants can cause these restrictive covenants to be unenforceable in their entirety if the drafting party is sophisticated and otherwise should have recognized the overly-broad nature of the restrictive covenant.
When drafting restrictive covenants for transactions, it is important to consult experienced counsel who can provide advice and guidance to ensure that any proposed restrictive covenants are reasonable and enforceable.
Please contact a Hinckley Allen attorney if you need counsel to ensure your covenants are effective and enforceable.